Taming Financial Biases

Every year DALBAR, an independent researcher for the financial community, releases its report on what returns the “average” investor earns versus the S&P 500 stock index. This year it reported that over a 20-year period, the average investor earned 5.96% while the S&P 500 earned 7.47%. That’s a difference of 1.51%, which doesn’t sound like much until you do the math over 20 years. The average investor’s $100,000 investment in that time will have earned 25% less — that’s $104,118 — than what the S&P 500 returned.

Why? Because the average investor has a tendency to buy high and sell low. That investor’s judgment is swayed by at least three factors: loss aversion bias, confirmation bias, and recency bias. Here’s what they are and how to tame them:

● Loss aversion bias: The pain of losing is psychologically twice as powerful as the pleasure of gaining. Instead of potential gain, we focus on the risk of loss. So when average investors see a dip in the market, they freak out and sell. Antidotes: Gratitude, thinking long-term, and being realistic and honest about the likelihood of catastrophic outcomes.
● Confirmation bias: We often tend to interpret new evidence as confirmation of our existing beliefs, even with plenty of evidence to the contrary. The investor who believes a stock is going up will hang in there after finding the one internet story out of 10 that supports the belief. Antidotes: Create a strong information filter and ask yourself, “Is that 100% really true and how do I know?”. Think for yourself and be willing to challenge your perceptions of yourself.
● Recency bias: This is favoring recent events over old ones, even if the recent ones are not as relevant. The average investor sees a downward or upward trajectory and makes a short-term decision to buy or sell based on a short time frame, often buying or selling at the wrong time. Antidotes: Create a self-imposed time frame for taking action (e.g., wait 48 hours before executing that trade based on today’s news), focus on goals rather than returns and reduce daily news consumption.

People hire financial planners like me precisely because they want to keep their emotions out of investing, or they want support amid all of the bad news, downturns and scary projections. They want to know how to reach their life goals and make their money support those goals. If you would like help with your planning and investing — or reducing your biases in life or finance — please reach out.